Earnings Alert: First Quarter Likely to Disappoint Investors

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Investors who think the recent run-up in stocks is a sign that the market has turned a corner could be in for a rude awakening once first-quarter earnings season starts next week.

While earnings could be modestly better than the previous quarter—and present some buying opportunities for selected companies—market pros warn that stabilization is about the best the market can hope for.

"If investors are expecting a significant improvement in first-quarter earnings to show this is no longer a dead-cat bounce or a short bull run in a bear market, they will be disappointed," says Michael Kresh, president of M.D. Kresh Financial Services in Islandia, N.Y. "What they should be expecting is moderate improvement or trend-changing."

Looking for signs that things aren't getting any worse—and making market plays off that—could be key to maintaining the March rally, which has brought the major indexes closer to breakeven for a turbulent 2009.

Market pros say now is a good time to buy stocks for investors who keep their optimism tempered with economic realities.

"We're getting the kinds of things you would hope to get to justify a rally in the market," says John Buckingham, chief investment officer at Al Frank Asset Management in Laguna Beach, Calif. "The hope is that in the Q1 earnings season, companies are not missing expectations by wide margins. The hope is that executives are going to focus on the long-term opportunities that they can have as opposed to the short-term problems that they're facing."

Even before first-quarter earnings are reported—Dow component Alcoa (NYSE: aa) is the first to post results next Tuesday—a number of companies already have warned that consumer weakness will make 2009 a trying time for profits. Some even have dispatched with providing guidance for the year, reasoning that conditions are too volatile to generate reliable forecasts.

At the same time, a mid-March surge in the markets has some in the investment community talking about a possible bottoming process as home sales improve modestly and other economic signs point at least to stabilization.

But an overabundance of hope could prove poison for sustaining the rally.

"I expect this quarter to be better than last quarter, but not as much to establish that we've completely turned the corner in the recession," Kresh says. "I wouldn't be jumping up and down in anticipation of phenomenal profits for this quarter."

"Investors shouldn't be looking for much for the first quarter," adds Kevin Mahn, portfolio manager at Hennion & Walsh in Parsippany, N.J. "I still think that we're close to a point of market recovery, but the economy's got at least two more quarters yet."

'Whisper Number' vs. Reality

How investors react to earnings reports is always an interesting dynamic.

During boom periods, such as the dot-com surge in the 1990s, many investors looked beyond company forecasts and instead paid heed to the so-called "whisper number" of what Wall Street really expected of earnings reports. If a company reported earnings that were below inflated whisper numbers, that sometimes led to stock selloffs.

Conversely, in the current type of market, numbers that are bad but not as low as bearish whisper numbers can entice buyers. That phenomenon was apparent last week in less-than-stellar numbers from high-end retailer Tiffany (NYSE: TIF), food producer ConAgra (NYSE: CAG), and Dr. Pepper Snapple (NYSE: DPS), all of which had difficult quarters but beat diminished expectations.

"The delta, or the rate of change, is what becomes important in this market environment," Buckingham says. "The market would be much happier if you go down 20 percent and you stabilize than if you are down 10 percent then another 10 percent and keep going down and down and down."

Most investors understand the economy is bad, but need glimmers of hope to motivate them to get back into the market.

As such, first-quarter earnings could serve as an important benchmark for how Wall Street digs itself out of its bear malaise.

"This rally so far seems to be pinned on the banking system having some sort of stabilization ... that things did not get worse than management expected," says Gary Flam, portfolio manager at Bel Air Investment Advisors in Los Angeles. "That's the first leg of it. That gives investors some comfort of what it's going to look like."

Broadly speaking, earnings are expected to be modestly better than the fourth quarter of 2008 as companies reduce inventory, cut personnel and get a better handle of what things are like going forward.

The climate has many portfolio managers optimistic that the market is nearing a reality point, away from the oversold conditions that have prevailed and towards a climate ripe for buying.

"There's enough positive economic news from companies that suggests that what the government did over the last few weeks is helping to set a floor," Kresh says. "So we can be moving up from what was a very, very scary period two weeks ago."'

While Kresh says his strategy will be broad-based, he has aggressively bought Warren Buffett's Berkshire Hathaway (: BRK) and CNBC.com-parent General Electric (NYSE: GE) since March 16.

Likewise, Buckingham says investors with long-range time horizons--three to five years--should be using the current climate as a buying opportunity.

"It's going to be a delicate balance and we are in an era where you get sold if you paint too rosy of a picture. You have to be very careful."